• Central tax devolution to States is guided by Finance Commission recommendations; while 15th FC norms are in force, 16th FC recommendations are awaited. GSDP (Gross State Domestic Product) is crucial for the 16th Finance Commission (FC) as states, especially high-performing ones, demand it be a major factor in central tax devolution, arguing it better reflects tax-raising capacity than population, while weaker states seek higher shares and borrowing limits for development, all in a context of increased central cesses and GST-related revenue issues, making the 16th FC''s recommendations vital for balancing fiscal federalism.
• Rising Centre–State tensions over tax devolution have revived debate on using GSDP as a criterion.

What is Tax Devolution?

• Tax devolution refers to the distribution of tax revenues between the central government and the state governments. It is a constitutional mechanism established to allocate the proceeds of certain taxes among the Union and the states in a fair and equitable manner.
• Article 280(3)(a) of the Constitution of India mandates that the Finance Commission (FC) has the responsibility to make recommendations regarding the division of the net proceeds of taxes between the Union and the states.

What GSDP Means for the 16th FC:

• The 16th Finance Commission (16th FC) of India, chaired by Dr. Arvind Panagariya, was constituted in late 2023 and submitted its report in November 2025, recommending fiscal arrangements for 2026-2031.
• Tax Base Indicator: GSDP shows a state''s economic size and output, indicating its potential to generate taxes, making it a strong proxy for tax accrual.
• State Demands: Developed states like Tamil Nadu and Maharashtra want more weightage for GSDP (contribution to national GDP) in the devolution formula, reducing reliance on population/income distance.
• High Performers'' Grievance: States contributing more to national GDP feel shortchanged as they receive less from central taxes, a trend highlighted by the 15th FC''s formula.

Key Issues & Demands for the 16th FC (Chaired by Arvind Panagariya):

• Increased Tax Devolution: States push for a higher share (e.g., 50%) of central taxes from the current 41%.
• Relaxed Borrowing Limits: Climate-affected and developing states seek extra borrowing space (beyond 3% of GSDP) for development.
• Special Grants: Hilly, border, and disaster-prone states request more grants for infrastructure and climate resilience.
• Addressing Fiscal Imbalances: Concerns over GST impact, rising cesses (not shared with states), and Centrally Sponsored Schemes (CSS) affecting state autonomy.

The 16th FC''s Role:

• It recommends the principles for dividing central taxes (vertical devolution) and allocating funds among states (horizontal devolution) for the period starting April 1, 2026.
• Its report, submitted in November 2025, addresses these complex issues, with Parliament yet to approve its recommendations.

Gross State Domestic Product (GSDP)

• Definition: GSDP measures the total economic output produced within a State, capturing the scale and structure of its economy.
• Tax Base Indicator: It reflects income generation and production activity, which form the underlying base for both direct and indirect taxes.
• Uniform Effort Assumption: Since tax effort does not vary widely across States, GSDP reasonably approximates tax-accrual capacity at the State level.

Why Tax Devolution is Contested?

• GST Centralisation: After GST, States surrendered key taxation powers; GST compensation ended in June 2022, while many States still report revenue shortfalls relative to pre-GST growth trends.
• Cess Expansion: Cesses and surcharges form ~22–25% of the Centre’s gross tax revenue, but are not shareable with States, shrinking the divisible pool (Union Budget data).
• CSS Dominance: Centrally Sponsored Schemes account for ~40% of Central transfers, limiting States’ flexibility to allocate funds based on local priorities (RBI State Finances).
• Equity Skew: Under the 15th FC, weight for income distance (45%) and population (15%) reduced the relative shares of fiscally high-performing States.
• Declining Autonomy: States’ own tax revenue averages ~7% of GSDP, while expenditure responsibilities continue to rise, widening vertical fiscal imbalance.

Why GSDP Is a Better Proxy for Tax Devolution?

• Direct Taxes Link: The correlation between GSDP and direct tax collections is 0.75 (2023–24), showing that States with larger economies contribute more to direct taxes.
• GST Alignment: GSDP has a 0.91 correlation with GST collections, reflecting GST’s destination-based nature and close link with economic activity.
• Efficiency–Equity Balance: GSDP correlates 0.81 with tax collections and 0.58 with devolution shares, balancing efficiency in contribution recognition with redistribution goals.
• Lower Distortion: Unlike PAN-based tax attribution, GSDP reduces distortions from headquarters-based booking and better reflects real production across States.

Winners and Losers Under GSDP-Based Formula

• Major Gainers: Maharashtra, Karnataka, Tamil Nadu and Gujarat would gain as their higher GSDP shares better reflect real economic output and tax contribution.
• Relative Losers: Uttar Pradesh, Bihar and Madhya Pradesh would see reduced shares since current transfers exceed their GSDP-based entitlement, though redistribution would continue.

Way Forward

• Addressing the Divisible Pool: A constitutional amendment or a binding commitment to cap cesses at 10% of GTR would ensure states get their fair share of the vertical pie.
• Specific Purpose Grants: Rather than altering the devolution formula, Centre can use Article 275 grants to support urban infrastructure in major industrial hubs. This supports the “engines of growth” without distorting the equity-based devolution formula.
• SDG-Linked Devolution: Link incentives to outcomes in Health, Education, and Climate Action, ensuring that funds result in tangible development in lagging states.